Cost of Capital

FINA 2203
Prof. Rik SEN

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This module: where it fits

Tool: Discounting Investment:

cash-flows
Capital Budgeting

What cash- flows?

Bond valuation

What discount rate?

Stock valuation
CAPM, WACC

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Capital Structure
The relative proportions of debt, equity, and
other securities that a firm has outstanding

These proportions are often calculated using

market value or the best estimate thereof 3
Balance Sheet: Market value relation

Market Value of Equity + Market Value of

Preferred Stock + Market Value of Debt =
Total Market Value of Assets
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Cost of capital
Average cost per dollar of capital
The cost to the firm is really the opportunity
cost from the investors perspective
When investors buy stocks or bonds of a company
they forgo the opportunity to invest elsewhere
The firm should offer the investors an expected
return equal to what they could earn elsewhere
for assuming the same level of risk
Firms overall cost of capital is a blend of costs
of different sources of its capital 5
Weighted Average Cost of Capital
For a firm with only equity,
rWACC = Equity Cost of Capital
For a firm with equity and debt

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Cost of debt capital
Expected returns on the firms debt
Well approximated by yield to maturity on the
firms debt (both new and existing) for firms
with low credit risk
Actually, the YTM is the maximum return
bondholders get if they hold the bond to maturity
If the bond defaults, they get less!
Taxes reduces the effective cost of debt
Effective cost of debt = rD (1 TC)
where, rD is the cost of debt, TC is the corporate tax rate7
Cost of preferred stock capital
Typically, holders of preferred stock are
promised a fixed dividend, which must be paid
in preference to any dividend to common
stockholders
When dividend on preferred stock is known
and fixed,
Prefered Dividend Div pfd
Cost of Preferred Stock Capital =
Preferred Stock Price Ppfd

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Example 1
Assume DuPonts class A preferred stock has a
price of $66.67 and an annual dividend of
$3.50. What is the cost of preferred stock?

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Cost of common stock capital
Option 1: Using Capital Asset Pricing Model
1. Estimate the firms beta of equity, typically by regressing
60 months of the companys returns against 60 months of
returns for a market proxy such as the S&P 500
2. Determine the risk-free rate, typically by using the yield on
Treasury bills or bonds
3. Estimate the market risk premium, typically by comparing
historical returns on a market proxy to risk-free rates
4. Apply the CAPM:

Cost of Equity = Risk-Free Rate + Equity Beta Market Risk Premium

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Example 2
Assume the equity beta of DuPont is 1.37, the
yield on ten-year Treasury notes is 3%, and
you estimate the market risk premium to be
6%. What is DuPonts cost of equity according
to CAPM?

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Cost of common stock capital
Option 2: Constant dividend growth model
Assuming constant growth rate of dividends

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Example 3
Assume that the average forecast for DuPonts
long-run earnings growth rate is 7.9%. With an
expected dividend in one year of $1.80 and a
price of $57.66, the CDGM estimate of
DuPonts cost of equity is:

Div1 $1.80
Cost of Equity = g 0.079 0.110 or 11.0%
PE $57.66

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Summary: Estimating the cost of equity

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WACC formula
rwacc = rEE% + rpfd P% + rD(1 TC)D%

For a company that does not have preferred stock, the

WACC formula condenses to:
rwacc = rEE% + rD(1 TC)D%

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Example
The expected return on Targets equity is
11.5%, and the firm has a yield to maturity on
its debt of 6%. Debt accounts for 18% and
equity for 82% of Targets total market value.
If its tax rate is 35%, what is this firms WACC?

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WACCs for real companies

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 WACC calculations in practice
Using Net Debt
Net Debt = Debt Cash and Risk-Free Securities
Market Value of Equity Net Debt
rWACC = rE rD (1 TC )
Enterprise Value Enterprise Value

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Using WACC to value a project
To value a project first calculate incremental
free cash flows from the project
Pay attention to amounts as well as timing
Next, discount these cash flows appropriately
using the firms WACC
This produces the value of the project which is
often called the levered value
Since this incorporates the benefit of tax
deduction by using firms after-tax cost of capital
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 Levered value of a project:

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Key assumptions
Average Risk
The market risk of the project is equivalent to the
average market risk of the firms investments
Constant Debt-Equity Ratio
The firm adjusts its leverage continuously to
maintain a constant ratio of the market value of
debt to the market value of equity
Limited Leverage Effects
The main effect of leverage on valuation is the
interest tax deduction and that any other factors
are not significant at the level of debt chosen 21
Are these assumptions true?
These assumptions are reasonable for many projects and
firms
The first assumption is likely to fit typical projects of firms
with investments concentrated in a single industry
The second assumption reflects the fact that firms tend to
increase their levels of debt as they grow larger
The third assumption is especially relevant for firms
without very high levels of debt where the interest tax
deduction is likely to be the most important factor
affecting the capital budgeting decision

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Example: Using WACC to value a project
DuPont is considering an investment that
would extend the life of one of its chemical
facilities for four years
The project would require upfront costs of
$6.67 million (in operating expense) plus a
$24 million investment in equipment
The equipment will be obsolete and become
worthless in four years. It will be depreciated
via straight-line over that period
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 During the next four years, DuPont expects
annual sales of $60 million per year from this
facility
Material costs and operating expenses are
expected to total $25 million and $9 million,
respectively, per year
DuPont expects no net working capital
requirements for the project, and it pays a tax
rate of 35%.
Assume WACC of Dupont is 10.33%
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 19 19 19 19
V
0
L
2
3
4
$59.80 million
1.1033 1.1033 1.1033 1.1033

NPV = $59.80 million - $28.34 million

= $31.46 million

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Cost of capital for an acquisition
The companys WACC is NOT the right one ot
use in the following cases
If a company is considering acquiring another
company in a different line of business
Or if a company wants to start a new division in a
new line of business
The discount rate (WACC) should be matched
to the risk of the cash flows being discounted

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 Suppose DuPont is considering acquiring Nike,
what cost of capital should DuPont use to
value this possible acquisition?
Nike faces different market risks than DuPont
does in its chemicals business
Because the risks are different, DuPonts WACC
would be inappropriate for valuing Nike
Instead, DuPont should calculate and use Nikes
WACC of 7.9% when assessing the acquisition
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Divisional cost of capital
The right cost of capital is used if the similar project/division is made within the company, then they can used the
previous project's cost of capital to reflect the new division. However, if the project is different, new cost of capital
has to be used (i.e Dupont wants to make division like Nike, so that they specifically has to see Nike's cost of

Now assume DuPont decides to create a

capital)

similar division internally, rather than buying

Nike. What should the cost of capital (WACC)
for the new division be? The cost of capital of the new division can't be used to
reflect the new division. The right cash flow must be used
to reflect the discount rate.

Answer: If DuPont plans to finance the division

with the same proportion of debt as is used by
Nike, then DuPont would use Nikes WACC as
the WACC for its new division Dupont can't use its own discount rate, instead it
used the Nike's discount rate.

Since the risk of cash flows in this case would be the

If they want to match the division with the Nike.
same as if Dupont acquired Nike 29
Costly external financing
Everything we did till now assumed that the
project is being financed using internal capital
that is already available
However, if money needs to be raised for
financing the project, associated costs should
simply be treated as additional cash outflows
necessary to the project in the NPV analysis
Issuing new equity or bonds carries a number of
costs
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